Image source: Wikimedia user Victorgrigas.
Data center REIT Digital Realty Trust (DLR +1.52%) has delivered impressive performance for investors in its decade or so as a public company. In fact, the stock is up 37% in the past month alone, and it now trades at an all-time high. After a performance like that, it's only natural to ask the question: Is Digital Realty Trust still a buy, or has it gotten too expensive?
The numbers and trends look good
It's easy to see why Digital Realty Trust's stock has performed well. The need for data storage has grown tremendously over the past decade or so, as has the need for data centers, especially those leased from an outside company (like Digital Realty). The company has managed to grow its core FFO by an average of 14% per year since its IPO, which has in turn resulted in a 12% annual dividend growth rate.
Source: Digital Realty Trust.
Plus, the industry trends look favorable for continued strong demand for data centers. Global IP traffic is expected to grow at a 23% rate through 2019, and mobile and cloud data traffic are expected to grow even faster.
Data source: Cisco Visual Networking Index and Ericsson Mobility Report. Graphic from Digital Realty Trust company presentation.
Digital Realty's customer list looks like a who's who of tech and finance, including such industry heavyweights as Facebook, Oracle, IBM, and JPMorgan Chase. The portfolio is geographically diverse, and there are only three tenants that account for more than 2.3% of the company's revenue (IBM, CenturyLink, and Equinix). Finally, the company's lease expirations are nicely staggered, and data centers tend to have a high retention rate.
The company has an investment-grade (BBB/Baa2) credit rating and a reasonable debt loan, which give it the financial flexibility to pursue attractive investment opportunities as they arise. The bottom line is that Digital Realty and the data industry are firing on all cylinders, and the company is doing so without excessive debt.
...but what about that high price?
A high stock price, or strong recent performance, doesn't make a stock expensive all by itself. In other words, the $88-and-change Digital Realty is trading for is a somewhat arbitrary number. Rather, what's important is the company's valuation relative to its earnings -- and its future potential.
With that in mind, we need to look at Digital Realty's price relative to its funds from operations, or FFO (the "earnings" of REITs). Digital Realty produced FFO of $4.85 in 2015, which makes its P/FFO ratio about 18.1. Using its "core" FFO of $5.26, which adjusts for one-time expenses and earnings that aren't part of the company's main business, Digital Realty trades for 16.7 times "earnings."
To put this in context, here's how Digital Realty's valuation stacks up to some other leading REITs.
|
Company |
2015 FFO |
P/FFO (TTM) |
2016 FFO Guidance |
Forward P/FFO (midpoint) |
|---|---|---|---|---|
|
Digital Realty Trust |
$5.26 |
16.7 |
$5.50-$5.70 |
15.7 |
|
Realty Income Corporation |
$2.74 |
22.3 |
$2.85-$2.90 |
21.3 |
|
Equity Residential |
$3.46 |
21.7 |
$3.00-$3.20 |
24.2 |
|
Simon Property Group |
$9.86 |
20.8 |
$10.70-$10.80 |
19.1 |
Source: Company financials.
So, while Digital Realty Trust may look expensive at first glance, the stock is actually on the low end of the REIT valuation spectrum. Granted, there are some reasons for this -- specifically, Digital Realty's newness and the risks of investing in a rapidly growing property type. For example, Realty Income has a long track record of market-beating performance and years of steady dividend growth, and the retail real estate industry is much more established and stable (less risky) than data centers.
Realty Income invests in retail properties that will always be in demand, such as drug stores, restaurants, and fitness centers. All of these will probably still be in demand in 100 years. Will people still need data centers in 100 years? Maybe, but maybe not. For all we know, technology will advance to a point that somehow makes data centers obsolete. So, although Digital Realty is cheaper than Realty Income, it is cheaper to compensate investors for the additional risk. Even so, the point here is that Digital Realty is still reasonably priced, despite the recent performance.
To buy, or not to buy?
Digital Realty Trust is an excellent play on the exponentially growing need for data storage, and it still looks to be reasonably valued. Having said that, keep in mind that this is not the same as investing in Realty Income, Simon Property Group, or any of the major REITs in a more stable type of real estate. Digital Realty is likely to be slightly more volatile, at least while the data storage industry is still growing at such a rapid pace, but investors with the stomach to ride out the industry's growth phase could be handsomely rewarded.
